THE FUTURE OF MONETARY POLICY: COORDINATION AND FINANCIAL STABILITY?

There has been a lot of debate surrounding monetary policy since the 2008 economic crisis. So-called “quantitative easing” in the United States has vocal proponents and critics, and now people and governments around the world are coming to question what central banks should or should not be doing to ensure that the global economy is running smoothly. Recently, Masaaki Shirakawa, the former governor of the Bank of Japan, spoke at UC San Diego and gave his thoughts on the future of monetary policy. I was fortunate enough to interview him, and the major points that came up in his lecture and our interview seemed particularly relevant to post-2008 monetary policy—efforts at coordination by central banks and the central banker’s role in promoting financial stability.

Since 2008 there have been many attempts to coordinate monetary policy and meetings among the world’s central bankers. According to Mr. Shirakawa, these efforts are absolutely necessary to ensure that the global economy is working smoothly. Full cooperation in monetary policy setting—aiming to set at a global optimum rather than a local one—might be ideal in theory, however, such coordination is difficult to sustain in practice.

Monetary policymakers are concerned with the domestic economy first and foremost, and they should be, given that they are governed by central bank law in each jurisdiction. However, monetary policy does have spillover effects that need to be dealt with. One example of this is the recent public argument between Ben Bernanke and several emerging market central banks over QE. If the U.S. government keeps interest rates low, then investors will seek to move their holdings abroad to take advantage of relatively higher interest rates. This floods the economies of emerging markets with cash as the increased demand raises the value of their currency; this can have severe repercussions and as such, is a source of worry for many emerging markets. One possible solution is for the emerging market countries themselves to adjust their monetary policy to achieve domestic stability. However, as Mr. Shirakawa discussed in the context of Japan—which has had an official interest rate near zero for some years and therefore cannot narrow the interest rate differential between it and the United States—this is not always possible. The interest rate differential is a key determinant of the exchange rate, and so the dollar-yen exchange rate is being affected.

There is another issue that the financial crisis highlighted—the need for stability in the financial system. If the central banks were to take up this issue as a mandate, it would be a fundamental change in direction for the global economy. According to Mr. Shirakawa, before the crisis the logic of central bankers (in focusing heavily on inflation targeting) was as follows: low and stable inflation leads to macroeconomic stability and this is complementary to financial stability; to the extent that we need to focus on financial stability, we should focus on the stability of each individual financial institution.

Obviously, this did not work so well in preventing the financial crisis of 2008 and the central banks of the world were stuck in a big mess.

The question then becomes this: What can the central banks do about financial stability before a crisis? The answer is not much on its own. There are many difficulties in promoting financial stability not least of which is defining the term [1]. For Mr. Shirakawa, “monetary policy alone [cannot] solve this situation,” rather, “we need good monetary policy good supervision and good regulation.” Central banks are doing what they can to address this issue. There have been recent efforts by central banks to coordinate more on issues of the payment system and foreign currency swaps, which has helped keep money flowing in the financial system in a time of crisis. The issue of financial stability is difficult for central banks to address, however, because they do not have all of the tools needed and knowledge about the threat to financial stability in real time.

These two issues are just two of many that central bankers are grappling with as they try to figure out the role monetary policy should play following the 2008 crisis. It seems unlikely that the traditional focus—short term inflation targeting—in most central banks will continue completely unchanged, however it is unclear where we will go from here. More coordination among central banks seems like a plausible solution, but how much and on what issues? As with the question of what to do with “too big to fail” banks, on the questions of financial stability and regulation of the financial system, we still don’t seem to have a good answer.